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Thursday, May 15, 2014

If I were to ask you to bet your money on the future success of your investment in a property company, whom would you choose to become the CEO of your company, Dato’ Liew Kee Sin of Eco World Development Berhad or your good friend Datuk Bill Ch'ng Chong Poh of Malaysia Pacific Corporation?

If I can trust your IQ, betting on the most capable person would make greater sense for you than betting on your good friend.

The same philosophy holds true while investing in stocks. You must not put your money on a stock whose name you like the most or whose chairman is your good friend. Instead, you must invest in the stock of a business you believe has the maximum potential.

But this is one reality that most investors forget – that…

“… a stock is not just a piece of paper that has a name, but a share of a business that has real assets and profits.”

While buying a stock, you should take the same approach as you would if you were buying an entire business. The only difference is that instead of buying the whole of the business, or a partnership in the business, you are only buying a tiny share.

“Investing is most intelligent when it is most businesslike,” Ben Graham.

The idea of buying a stock without understanding the company’s operating functions – its products and services, management quality, employee relations, raw material sources and expenses, plant and equipment, capital reinvestment requirements, and needs for working capital – is unacceptable.

This mentality reflects the attitude of a business owner as opposed to a stock owner, and is the only mentality an investor should have. Owners of stocks who perceive that they merely own a piece of paper are far removed from the company’s financial statements.

They behave as if the stock market’s ever-changing price is a more accurate reflection of their stock’s value than the business’s balance sheet, income statement, and cash flows.

For Buffett and all other successful investors , the activities of a stock owner and a business owner are closely connected. Both should look at ownership of a business in the same way.

“I am a better investor because I am a businessman and a better businessman because I am an investor.” Warren Buffett

As explained in ‘The Warren Buffett Way’ by Robert Hagstrom, these are some of the key questions that you must answer to understand the business of a company.

Questions you must answer to understand a company’s business

Let’s discuss them in some detail here.

Questions on the core business

1. Is the business simple and understandable?

Never invest in a business you do not understand, for you can’t see the future opportunities and challenges before they arise. For example avoid special-purpose acquisition company (SPAC) if you don’t know how shell or blank-check companies that have no operations but just with a famous person can beat all other smart investors and established companies in the world to acquire great businesses and make big fortune for you.

“Acknowledging what you don't know is the dawning of wisdom.” Charlie Munger

2. Does the business have a consistent operating history?
Past performance is no guarantee for future success, but it shows if a business can operate under varying business conditions. Very often, that is the only thing we can rely on. Often naïve investors try invest beaten down stocks of companies with poor and untrustworthy management with the hope of turnaround of the business and hence its share price. Alas with the same management which has shown poor operating and management record, the turnover never does. As Buffet says:

“In the business world, the rear-view mirror is always clearer than the windshield.”

3. Does the business have favourable long term prospects?

‘Sustainable business’ is the key word here. Look for business that would most likely to last for many years to come. Stay away from companies that operate on trends and fads that can go out-dated in the future. Yes, like APACs.

Questions on management quality

4. Is management rational?

Now this is a very important part of an investor’s business analysis. The rationality of the management and its ability to deploy cash in a profitable manner is what separates a good business from a bad one.

Stay away from companies with ambition of empire building rather than focus on the efficiency of the core business.

Do not invest in companies which the CEOs know only how to talk c*** but care nothing about the running of the business.

Avoid with all cost companies with CEOs who are very good in speculating in shares.

5. Is management candid (frank) with its shareholders?

You don’t want to get into a future Enron, right? Look for managers that admit mistakes and take complete responsibility of their actions, rather than blaming everybody, and macroeconomic and political events and everything else.

6. Does management resist the institutional imperative?

Institutional imperative is the need for managers to act like their peers, no matter how irrational their actions may seem. Avoid managers who have the tendency to give in to peer pressure and do dumb things.

Questions on financial performance

7. What is the return on equity?

As we will understand later, return on equity is one of the most important metric for evaluating the profitability of companies. Earnings can be manipulated, but return on equity will show how worthy a business is.

Intuitively, if you put in RM100,000 capital into a business, are you looking at what earning the business makes, what are the margins, or are you more concern about the return of your capital?

Long term, return on equity will have a more profound effect on the company’s fortune than earnings.

My personal preference is Return of Invested Capitals though, but the principle is the same.

8. What are the profit margins?

A company that can convert its sales into profits is a successful business. The key is to keep costs at the minimum, and go for higher profits instead of higher market share. Avoid companies with low margins relative to its industry.

Finally, remember what Buffett said:

“If a business does well, the stock eventually follows.”

And don’t forget what Peter Lynch said too.

“ Wonderful companies become risky when people overpay for them.”

Hence you must have a good feel of the value of a company in order to avoid overpaying for a business.